QUALIPORT
Shares That Could Go Bust

By Maynard Paton (TMFMayn)
October 10, 2002

As many investors have discovered over the past year or two, investing in a business is an inherently risky proposition. Some companies will fail. Your shares can become worthless.

More often than not, debt causes the terminal downfall of a business. There's nothing worse for shareholders than a company struggling to meet its borrowing obligations. But how can you tell if a company has too much debt?

As this feature describes, the best way to quickly check a company's debt level is the interest cover calculation. Divide the company's operating profit by its interest payments and if the result is a low, single digit figure, then some serious investment thought is needed. The lower the interest cover, the more chance the company will have an unwelcome call from its lenders.

Dealing with debt

Given the harsh economic climate, there are plenty of companies presently struggling with their borrowings. This time last year, five familiar names were all shown to have debt problems (read more here). Here's how the shares have performed subsequently.

Company               Share Price      Share Price     Change
                      11/10/2001       10/10/2002       (%)
                         (p)               (p)

British Airways         155.0             94.5          -29
Corus                    44.5             36.0          -19
Invensys                 50.3             50.5           +0
Marconi                  17.0              1.3          -92
Telewest                 38.5              1.2          -97
Average                                                 -47

FTSE 100               5164.9           3717.5          -28          

As stated last year: "Of course, none of the above companies are 100% set for bankruptcy. Their respective managements are all busy selling off assets, firing employees or reviewing future financing options to help stave off further trouble. Indeed, for turnaround specialists, junk bond sleuths and pure stock market gamblers, the five companies could make for an attractive punt."

Well, the past twelve months did offer stock market gamblers the opportunity to at least double their money on four of those five shares. However, the debt burdens didn't go away and the shares eventually caught up with reality. Debt-for-equity swaps (Marconi (LSE: MONI)), mergers (Corus (LSE: CS.)) and disposals (Invensys (LSE: ISYS)) have all provided corporate lifelines.

Small cap trouble

Here are three more companies that are flirting with lending danger:

Company              Share Price      Market Value
                         (p)              (£m)

Big Food                 27.5             94.3
Ashtead                  30.5             99.3
Newcastle United         20.5             29.8

Annual results from food retailer Big Food (LSE: BFP) showed a £76m operating profit, a £33m net interest bill and £404m of net borrowings. So, interest cover of just 2.3 times wasn't encouraging. Then, following the completion of a refinancing package, Big Food suddenly warned of an £8m first half operating loss. Assuming a second half performance similar to last year's and adjusting for a £130m sale and leaseback, operating profits of about £28m could be expected to fund £20m of interest payments for the current year. Worrying.

Twelve-month numbers from Ashtead (LSE: AHT) highlighted a £81m operating profit, net interest payments of £52m and total net debt of £675m. Interest cover of just 1.6 times must have scared investors. In fact, the second half produced an operating profit of £31m, £28m of which then went on interest payments. A first quarter update from the plant hire firm subsequently provided little cheer on the trading front. Debt has been reduced slightly, but such an asset-heavy company will have an uphill struggle.

A bit unfair to pick on Newcastle United (LSE: NCU) perhaps, with many other football clubs in similar lending trouble. Full-year figures from the Toon Army showed an operating profit of £2m, interest payments of £4m and net debt of £45m. With no sign of either the club's ambition or wage bill abating, an interest cover figure of below one is asking for trouble.

Given the club's debt situation, it's quite surprising to note Newcastle paying a £4.5m dividend last year. With two executive directors and their families owning about 60% of the company, the board appears to be placing their personal finances ahead of the club's. No wonder ten other directors have resigned since Newcastle floated five years ago.

Go for broke

While the three companies highlighted may survive, shareholders will not necessarily prosper from their "recoveries". Investors in debt-troubled businesses can easily suffer from an unsympathetic financial restructure. Just ask any Marconi (LSE: MONI) shareholder.

In fact, Eurotunnel (LSE: ETL) is a classic example in this regard, with the company having had its fair share of rescue financing packages in the past. Suffice to say, Eurotunnel has not rewarded its shareholders; the shares have bobbed around the 60-70p mark for years as interest payments continue to absorb all of the company's profits.

So, for those looking for the next WPP (LSE: NXT) or Next (LSE: NXT) turnaround (two companies that narrowly escaped bankruptcy in the early nineties and recovered big time), be aware of  'survivorship bias'. What happened to Parkfield, Rush & Tomkins, Coloroll, Lowndes Queensway and British & Commonwealth in 1990? At the time, they all had debt troubles too. But they went bust.

While the above company debt analyses may look a little superficial, prudent long-term investors don't need much more information to stay well away. The risks are just not worth it, especially when there are plenty of debt-free companies valued on reasonable ratings available elsewhere.

More: Shares That Could Go Bust (2001)